Question

You have been assigned the role to Advise the FEDERAL RESERVE on how to BEST manage the Exchange Rate. Write a detailed note explaining to the Governor what tools are available and what would be your strategy in defending the currency against speculative market forces?

Answer 1

Q: How to best manage The Exchange Rate?

The exchange rate for U.S is mostly related to Dollar value with respect to other currencies.To best manage exchange rate federal reserve need to take action up on its rate on banks in the U.S as the change in federal reserve rate it can bring impact on dollar exchange rate with respect to other currencies through supply of money.

One thing is banks interest rate, exchange rate and reserve requirement for banks affect exchange rate function.

By changing interest rate in the economy, by controlling inflation rate, bank reserve ratio, Liquidity ratio.

Tools available for management of Exchange rate:

Using Hedge to forward contract market:

By using forward contract hedging we can hedge transaction exposure.

Using hedge with money market:

Firms which have access to international money market can use money market hedging tools to manage transaction exposure.

Option tools;

Buy/sell function can hedge exchange rate risk.

Bank reserve ratio change can give effect on exchange rate.

Strategy in Defending Currency against speculation:

Currency speculation is when investor feels the exchange rate is wrongly valued and so buy/sell in currency making profit.

In order to defend currency speculation federal reserve need to raise interest rate so that currency of its country becomes more attractive and high yielding . By this activites the currency of one country can be sold and becomes profitable.